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The Stock Market Is Patently Unfair
By Arne Alsin
RealMoney.com Contributor

URL: http://www.thestreet.com/p/rmoney/marketcommentary/10281223.html

4/25/2006 8:02 AM EDT

In a fair market, the property of investors is secure and protected, the playing field is level, and rules are uniformly enforced.

Unfortunately for investors, that does not describe the current condition of the stock market. The current stock market is patently unfair.

The core issues are not complex. They are actually quite simple. Investors in stocks should consider these current realities:

A share may or may not be a share.

A vote may or may not be a vote.

A trade may or may not be a trade.

Shares, votes, and trades --- these involve basic, fundamental market functions that should not be at issue. But they are at issue. And a fix is needed. Here are three core principles around which stock market reform should be focused:

Investors Deserve to Know What They Own

It should be a given that brokers fully disclose exactly what sort of asset an investor owns. It's not a given because there is a sizeable roadblock: Full disclosure does not serve the financial interests of brokers.

While it's true that it's your property and you deserve to know what is in your account, don't expect the brokers to be forthcoming anytime soon. If brokers had to disclose to investors when shares are removed from their margin accounts and lent to short sellers, it might put a crimp in their massively profitable stock-lending businesses.

Brokers often generate annual yields of 10%-15% or more when they lend out your property, and rates of 25% or more are not unusual for hard-to-borrow stocks. If there were full disclosure, investors might demand a share of those lending profits.

Taxes are one obvious reason to mandate full disclosure. I own the stock of Commerce Bank (CBH:NYSE) (CBH) in a margin account. Instead of getting the benefit of the 15% tax rate on dividends, last year I paid ordinary tax rates (which are more than double) on a sizable portion of my Commerce dividend (called "in lieu" income on the 1099 form).

Why is the special 15% dividend tax rate unavailable to me?

It's because I don't really have Commerce shares in my account --- despite what it says on my brokerage account statement. My broker lent my Commerce shares to a short seller who sold my shares to someone else. The borrower of my stock paid me an amount equal to the dividend, so I don't lose the dividend income. But since I don't actually have shares in my account, it's not a real dividend and the lower tax rate is not available.

Because of the lack of disclosure, taxpayers with dividend-paying stocks in their margin accounts have to wait until after the tax year is over to see if they have a "surprise" waiting for them on their form 1099.

One Share = One Vote

The Internal Revenue Service doesn't play games. When a company pays a dividend on a share of stock, only one shareholder gets the benefit of the 15% special tax rate. Even if it's lent out to multiple short sellers who sell to multiple buyers, only one shareholder gets the special tax rate. So brokers carefully track shares of stock for tax purposes.

When it comes to voting, however, brokers do a lousy job of tracking shares.

They literally trample on the right of shareholders to vote their stock. When your shares are lent to a short seller, you are supposed to lose your voting right --- it is supposed to follow the shares.

Amazingly, your broker has the gumption to send you voting proxy materials even when your shares have been lent. In what amounts to a full-blown charade, your broker allows you to vote shares that you think you have, but really don't have.

The net result of this nonsense is predictable enough: Overvoting is a rampant problem. A trade organization (made up of stock transfer agents) recently reviewed shareholder votes for over 300 companies and found evidence of overvoting in every single case.

Some brokers have procedures in place to summarily reduce the vote totals that they report so that they don't report excess votes. Rather than report 150,000 votes when the brokerage has only 100,000 shares, for example, the broker simply trims the vote. So, as a shareholder, your vote may actually be worth only ½ or ¾ of a vote, or whatever fraction that the broker deems fair and equitable.

The voting issue is a mess that needs to be cleaned up. The right to vote should be tied to share ownership, with enforcement of a "one share, one vote" rule. If the brokers can figure out who gets the special 15% dividend tax rate, then they can figure out who has the right to vote.

Trades Mean Something

In my column last week, Why Does Failure to Deliver Go Unpunished? , I described purchasing several blocks of shares of Overstock (OSTK:Nasdaq) , shares that were not delivered within the required three-day settlement period, known as T+3. For four separate purchases, cash was taken from my mutual fund's account on the stipulated settlement date (T+3) and held in a separate account by a custodian bank. We waited as long as three weeks to get delivery of our property.

Since that column, I've heard similar stories from many other investors and money managers, including one from a major bank that has been waiting for delivery of Overstock shares for two months.

The manager at this bank says that the broker is going to cancel the trade. This should not happen.

In a fair market, with trading rules that are enforced, it would not happen. With over 300 stocks suffering from significant delivery delays, it's clear that there is a systemic problem in the market. The T+3 rule is frequently violated and the violators go unpunished.

Legislators Need to Get Involved

If a market can be abused, it will be abused. Hundreds of companies have failure-to-deliver problems. Shareholder voting is a farce. Trading rules are being ignored. Investors can't say with certainty what is in their accounts.

To hand off the market's problems to the Securities and Exchange Commission to solve behind closed doors is a less-than-optimal solution. In the interest of maintaining investor confidence, these issues are better served and solved in an open, transparent forum like Congress.

All that is needed is a member of Congress with enough courage and foresight to tackle these problems, before they develop into a crisis.